CPA, “So, where are you getting your goods made?”
Start-up, “We are getting everything made in China.”
CPA, “What are your gross profit percentages like?”
Start-up, “They are great! We are getting like 65% so far!”
CPA, “Wow! That is great! That’s like 15 to 20% higher than I would expect for a start-up. Is your price point higher than the competition?”
Start-up, “No, we are right on the mark with our tee’s, shorts and denim.”
CPA, “This is your third season so I wouldn’t think that your volume is at a level where you are getting discounts from the factory. Is that the case?”
Start-up, “No, we are a ways off from the volume discounts. In fact, we are still required to put up 50% before they start production and the other 50% before they ship.”
CPA, “Speaking of shipping, how do you get your goods shipped over? Is it all by sea or is there some air freight mixed in there?”
Start-up, “We try to get everything shipped by sea but if things are getting late then we have to go with air so that we don’t miss our delivery dates. So, I guess it is about 50/50 since our shipments are usually held up because our payment to get the factory to ship is late.”
… and so goes the conversation hitting on various points of items above and beyond the actual unit price of an item that should be included in inventory under Generally Accepted Accounting Principles (“GAAP”) in the USA as issued by the Financial Accounting Standards Board (“FASB”). To very, very briefly summarize the FASB’s point of view on inventory costing; inventories should include all costs, both direct and indirect, that are incurred to bring inventory to it’s current condition and location. To actually put this into practice varies from a simple task say for inventory items that are purchased as finished goods from a local vendor (ex. screened tees from a local printer who supplies the blanks) to a complex exercise for inventory items that are manufactured in a company’s own factory overseas. Most companies in the action sports industry will have a mix of inventory items that require different levels of costing analysis but they generally will not require the more complex calculation and allocation of the various types of direct and indirect costs associated with the manufacturing process (labor, utilities, rent, administrative expenses…) as production is outsourced to various vendors.
In the fabricated conversation above the point being made is that unless inventory costing is understood and properly performed, company management may have an inaccurate view of the company’s actual gross profit margins for its inventory items (think of a hoodie that is screened and imported from China, at a unit cost of $10 and a wholesale price of $20 based on a 50% gross margin). This inaccurate view may drive inaccurate production decisions, pricing to customers, overall sales decisions, commissions, compensation, misstated financial statements, inaccurate income tax returns… the list can go on and on. This is because inventory is the core of the business model for an action sports company whether it be apparel, accessories or hard goods and like the saying goes “garbage in, garbage out”. (Now think of that same hoodie from the example before with a unit price of $10, now add in allocated per unit charges for customs, duties, broker charges, sea/air freight, insurance, and inland freight. The actual cost is now up to $12 which for the same 50% gross profit would require a wholesale price of $24, but the company already committed to a $20 price to its customer, so now the actual gross profit percent on this item is down from 50% to 40%… and that is before other non-specific cost of goods sold items included in the income statement further drive down the company’s overall gross profit margin…)
So the moral to the story, once the design department is done hammering out every last detail on the cost sheet with regards to the actual production of the inventory, meet up with the accountant (some of us are actually pretty cool people…) and make sure the cost sheet includes line items for everything that is required under GAAP to fully cost the item. This may sting a little up front and cause a little reworking to get to the margin where you want it if the price point is set but it is better than the alternative of thinking that you are killing it at market and then having your accountant break the news to you after everything is already sold.
Orion Barca, CPA
Barca Company, Inc.